The Choice between Real and Accounting Earnings Management

This study develops a theoretical model and presents empirical evidence on crosssectional variation in managers’ choice of AEM and REM. In particular, it studies how AEM and REM are jointly affected by firms’ growth prospects, managers’ market-based compensation incentives, and the cost of real earnings management. The model yields several testable hypotheses. First, when the firm’s growth prospects are good, the firm will boost current period earnings through AEM, but not REM. Second, when the sensitivity of the manager’s compensation to stock price and/or value-relevance of earnings go up, the firm will use AEM, but not REM, to inflate current period earnings. Third, when the cost of REM increases, the manager will reduce opportunistic excess investment. Meanwhile, AEM decreases in the cost of REM. Firms that barely meet or beat analysts’ forecasts are used to test the model’s predictions. The results are in general consistent with the hypotheses.